Litman Gregory Masters Alternative Strategies Fund Third Quarter 2017 Attribution

The Litman Gregory Masters Alternative Strategies Fund (Institutional Share Class) gained 1.34% for the quarter ending September 30, 2017. During the same period, the Morningstar Multialternative Category gained 1.49% and 3-month LIBOR returned 0.32%. Year to date through September 30, the fund has gained 3.81%, while the Morningstar category and 3-month LIBOR returned 3.79% and 0.86%, respectively.i Since inception six years ago, the fund’s annual return is 5.41%, compared to a 1.93% return for the Morningstar category, with similar volatility (3.1%); 3-month LIBOR returned 0.49%.

Performance quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the funds may be lower or higher than the performance quoted. To obtain standardized performance of the funds, and performance as of the most recently completed calendar month, please visit www.mastersfunds.com.

Quarterly Review

Besides the addition of DCI, it was a relatively quiet quarter for the fund. Our four original sub-advisors (DoubleLine, FPA, Loomis Sayles, and Water Island) remain more defensively positioned, not finding this to be a particularly attractive environment—in terms of expected returns—to take on more risk within their mandates. Passport’s portfolio is around the middle of its broad net exposure range, with a focus on what they believe are idiosyncratic ideas with distinct catalysts and return drivers that are not dependent on the overall market’s direction, such as their position in Saudi Arabian stocks. DCI’s on-boarding went smoothly and their portfolio is positioned and performing as expected.

We continue to see each of our managers executing their investment processes with discipline, consistent with our expectations when we hired them. The recent period of very low volatility, elevated valuations, and depressed yields is not a particularly fertile environment for our managers’ opportunistic yet risk-aware approaches. Nevertheless, performance has been solid. We like how the fund is positioned in the event volatility returns to financial markets. (We are confident it will return someday.) We expect our managers and the fund’s “all-weather” construction to shine in such a period. Consistent with their history, we also believe our managers will then find excellent opportunities to put their dry powder to work; the flexible investment mandates they employ for our fund will enable them to do so, which should generate attractive longer-term returns.

Litman Gregory Masters Alternative Strategies Fund Risk/Return Statistics 9/30/17
 
MASFX
Bloomberg Barclays Agg Bond
Russell 1000
Morningstar Multi-Alternatives Category
Annualized Return
5.41 2.57 16.76 1.93
Total Cumulative Return
37.16 16.47 153.39 12.13
Annualized Std. Deviation
3.15 2.74 10.50 3.14
Sharpe Ratio (Annualized)
1.63 0.87 1.52 0.56
Beta (to Russell 1000)
0.25 -0.02 1.00 0.26
Correlation of MASFX to…
1.00 -0.12 0.79 0.81
Worst Drawdown
-6.94 -4.52 -12.41 -9.33
Worst 12-Month Return
-4.49 -2.47 -7.21 -6.90
% Positive 12-Month Periods
87.50% 81.25% 95.31% 81.25%
Upside Capture (vs. Russell 1000)
31.59 8.37 100.00 21.46
Downside Capture (vs. Russell 1000)
27.64 -8.30 100.00 41.67
Since inception (9/30/11).
Worst Drawdown based on weekly returns
Past performance is no guarantee of future results

 

 

 

 

Quarterly Portfolio Commentary

Performance of Managers

For the quarter, all six managers produced positive returns. Passport’s Long-Short Equity strategy gained 2.60%, FPA’s Contrarian Opportunity strategy gained 2.02%, Loomis Sayles’s Absolute-Return Fixed-Income strategy gained 1.88%, DoubleLine’s Opportunistic Income strategy was up 1.50%, DCI’s Long-Short Credit strategy gained 0.86%, and Water Island’s Arbitrage and Event-Driven strategy rose 0.75% (all returns are net of the management fee each sub-advisor charges the fund).

Key performance drivers and positioning by strategy

DCI: We added DCI as a sub-advisor on the fund in early July. Their Long-Short Credit strategy gained 0.86% through the end of the quarter. Although it is obviously a very short-term period, the strategy’s overall performance has been broadly in line with expectations despite significant market gyrations in rates, currencies, commodities, and market risk appetite in the August–September period. The strategy’s performance was positive in all three months, positive in both the credit default swap (CDS) and cash bond sleeves of the strategy, and balanced across return drivers. Also as expected, the two sleeves have been additive with relatively low correlation to each other.

For the quarter, the CDS sleeve delivered modest gains as profits in media, rentals, and consumer goods sectors were somewhat offset by losses in energy, hospital, and insurance names. Short positions in highly leveraged wireless providers were the most profitable holdings as those names suffered from subscriber defections, dividend cuts, and increasing investor skepticism. Those gains were somewhat offset by losses on short positions in oil drillers and long positions in insurance names, which suffered hurricane-related losses. The bond sleeve was led by gains in positions in high-quality names in the technology, energy, mining, and consumer discretionary sectors. The strategy’s hedges performed as expected and were a net drag on returns as the rally in credit risk over the quarter led to negative performance from the credit beta hedges. Interest rates were mostly a net neutral factor. The strategy continues to seek out the best credit-selection opportunities, currently favoring long names in consumer durables, finance, and equipment, and shorts in wireless and retail. The portfolio has also moved from net short in energy to a modest net long.

DoubleLine: The DoubleLine Opportunistic Income strategy gained 1.50% in the third quarter, ahead of the 0.85% return for the Bloomberg Barclays U.S. Aggregate Bond Index. With interest rates broadly increasing by quarter-end, agency residential mortgage-backed securities (RMBS) underperformed relative to non-agency RMBS due to declining prices. Amongst agency RMBS, inverse interest-only securities detracted the most from performance while fixed-rate collateralized mortgage obligations (CMO) were the best performers. In contrast, non-agency RMBS performed well during the period with valuations increasing across the credit spectrum. Alt-A bonds were the largest contributors of total return due to the combination of strong price appreciation and interest carry. Subprime bonds exhibited the highest absolute total returns, aided by healthy cash flows for the quarter. Other structured credit sectors such as collateralized loan obligations (CLO) and commercial mortgage-backed securities (CMBS) contributed positively to performance, driven primarily from high interest carry. Municipals detracted from performance due to a decline in valuations caused by ongoing concerns related to Puerto Rico.

The portfolio remains risk-integrated, with credit-sensitive sectors (primarily non-agency RMBS, which remains the largest allocation in the portfolio at 69%) balanced by mostly longer-duration, interest rate–sensitive agency RMBS, accounting for approximately 19%. The other credit-sensitive allocations (CLOs, CMBS, asset-backed securities, and municipals) make up 9%. The cash position has come down to roughly 3% of the portfolio. The portfolio ended the quarter with a calculated duration of 4.9 years and a yield to maturity of 4.3%.

FPA: The FPA Contrarian Opportunity strategy gained 2.02% in the third quarter, a solid absolute return considering its 44% cash position. The top contributors for the quarter were Baidu, Aon, Citigroup, Alcoa, and Rush Enterprises. The largest detractors were the Naspers/Tencent pair trade, Mylan, United Technologies, General Electric, and Oracle.

During the quarter, the managers established a couple of new positions and added to their existing position in WPP. The biggest new addition was an automobile long/short pair trade involving a 2.4% long position in Porsche and a comparable short position in a basket of nine other global auto manufacturers. Positions in Alcoa, General Electric, and Citigroup were all trimmed, as was the Naspers/Tencent pair trade.

The portfolio’s gross long exposure to equities increased slightly to 56%, with 15% in foreign stocks. Net equity exposure is 48%. Credit holdings are 7% of assets. Financials remains the largest sector concentration at approximately 19%, with the largest holdings being Aon, Citigroup, AIG, Bank of America, and CIT Group. Technology is the second-biggest sector exposure at 11%, including high-quality franchises like Oracle (the portfolio’s top holding), Microsoft, Cisco Systems, TE Connectivity, and Alphabet. Industrials comprise 10% of the portfolio, including GE, United Technologies, and aerospace-focused companies (Arconic and Esterline). The portfolio’s large cash position is a function of expensive valuations and generally unattractive risk/return profiles across equity and high-yield bond markets.

Loomis Sayles: The Loomis Sayles Absolute-Return Fixed-Income strategy returned 1.88%, driven by gains across most of the sectors within the strategy. High-yield corporate bonds were the biggest contributor to performance as spreads tightened during the quarter. Recent strength has been driven by improved credit fundamentals, lower default expectations, and higher oil prices supporting a recovery in the energy sector. Individual energy, consumer non-cyclical, and insurance names benefited performance the most. Securitized assets, particularly ABS and non-agency RMBS holdings, aided performance, as fundamentals remained stable across all sectors and spreads tightened.

Emerging-market exposure also helped returns, as credits in this space rallied during the quarter, despite a pickup in volatility due to rising geopolitical tensions. Markets seemed to shrug off these concerns, however, focusing instead on improving global growth fundamentals. The portfolio’s exposure to emerging-market energy and consumer non-cyclical securities led the contribution to return. Equity holdings also bolstered returns during the quarter. Higher oil prices drove gains in the strategy’s small equity allocation, which is dominated by energy positions. The managers remain comfortable holding these equities as they expect oil prices will continue to inch higher over the next year. Individual consumer cyclical and technology names also added to returns.

The strategy’s risk management tools, primarily equity index futures and options and interest rate futures, detracted from performance. Most of the decline was attributed to the rally in U.S. equities, which caused the portfolio’s short hedges in the S&P 500, Russell 2000, and Financial SPDR to decline. Loomis continues to use these tools to mitigate the portfolio’s downside and hedge market risk.

In terms of portfolio positioning, the allocation to securitized assets increased meaningfully during the quarter and ended the period at a 21.6% net exposure. High-yield corporates decreased slightly and were the second-largest net exposure at 11%. Bank loans and investment-grade corporate exposures increased, ending the quarter at 10% and 6.5% net, respectively.

Passport: Passport’s Long-Short Equity strategy had another solid quarter, gaining 2.60%. Equity longs contributed approximately 5.9% while shorts detracted 3.2% (gross returns). On the long side, the Emerging Markets and MENA (Middle East & North Africa) sectors were the largest contributors (adding 2.6% and 1.7%, respectively), driven by investments in Chinese consumer/Internet stocks (Alibaba and Altaba) and Saudi Arabian stocks. The largest detractors were short positions in information technology (negative 0.7%) and diversified sectors (negative 0.6%), primarily comprising portfolio index hedges.

At quarter-end, the portfolio’s largest sector exposure (28% net long) was in Saudi Arabian stocks, specifically three banks (Alinma, Al Rajhi Bank, and NCB) and SABIC, the diversified manufacturing/petrochemicals company. Passport remains very bullish about the prospects for Saudi stocks as they see ongoing socio-economic reforms in the country along with the expectation that it will be added to the MSCI and FTSE emerging-market stock indexes over the next year or so, which should cause significant inflows into stocks domiciled there. The second-largest sector exposure (15% net long) is to other emerging-market stocks, primarily Chinese Internet names (Alibaba, Altaba, and JD.com) and a Brazilian-based meat producer. The third-largest sector allocation is to technology stocks (10% net long). Short positions are heaviest in the energy, industrials, and consumer discretionary sectors. Overall, the portfolio was 91% long and 28% short, for a 63% net long exposure, compared to 55% net exposure at the end of the second quarter.

Water Island: The Arbitrage and Event-Driven strategy returned 0.75% in the quarter. All three sub-strategies contributed positively to returns, with Credit Opportunities being the largest, followed by Merger Arbitrage and Equity Special Situations. At the end of the quarter, 61% of the Water Island portfolio was in merger-arbitrage positions, 26% in equity special situations, and 17% in credit opportunities.

For the quarter, the top contributing position was an equity special situations investment in Altaba. In June 2017, upon completion of Verizon’s deal to acquire Yahoo!’s core business, the remaining assets within Yahoo! were renamed Altaba. This renamed entity now holds Yahoo!’s equity interests in Alibaba Group Holding and Yahoo! Japan, as well as a significant cash balance. Since 2015, Water Island has held long and short exposures in Yahoo! based on the company’s implied discount to its publicly held investments in Alibaba and Yahoo! Japan. In late June, Water Island used technical pressure from the Yahoo! index deletion to cover their short and establish a long position in Altaba. With the sale of Yahoo!’s core business complete, they believe the Altaba structure has been simplified and there’s a clearer opportunity for the company to monetize the market discount relative to its value in Alibaba and Yahoo! Japan.

The top detractor in the portfolio was a merger-arbitrage investment in Twenty-First Century Fox’s planned acquisition of Sky. In December 2016, Twenty-First Century Fox—a U.S. television and film company—entered into a definitive agreement to acquire the remaining 62% stake that it didn’t already own in Sky—a U.K. pay-television service operator—for $23 billion. This transaction comes on the back of Fox’s failed attempt to acquire Sky six years prior. In September 2017, the U.K. Secretary of State for Digital, Culture, Media, and Sport decided that she would have the Competition and Markets Authority review the transaction through the lens of broadcasting standards. This new layer of risk combined with political uncertainty lead to a decline in Sky’s stock price. Water Island continues to hold a position and expects the transaction to close in the first half of 2018.

In September, renewed concerns about regulatory restrictions on Chinese mergers and acquisition (M&A) activity in the United States caused volatility in merger-arbitrage spreads, which weighed on returns for the quarter. Yet at the same time, the market’s knee-jerk reaction has provided Water Island attractive entry points at which they may increase their exposure in deals where they believe the market has over-reacted. They also have an opportunity to reverse deals where they think a higher likelihood of regulatory interference now exists. While proper deal selection will be the key to capitalizing on these situations, Water Island’s ability to remain flexible and approach deals from both the long and short side is an advantage.

In terms of the credit opportunities sub-strategy, the credit market rally this year has meant fewer distressed situations. This is one of the core event types within the realm of Water Island’s current “harder catalyst/shorter duration” focus. As such, the portfolio’s allocation to credit opportunities has decreased compared to earlier in the year. In the absence of a reversal in the credit rally, Water Island anticipates this reduced allocation to remain for the foreseeable future. They intend to remain conservative in positioning and maintain a short duration profile. When volatility does arrive, the team believes they will find interesting opportunities for this sleeve in relative-value/curve-steepener trades and in hedged convertible bond trades.

Finally, related to the equity special situations sleeve, one notable development is the decline in the volume of speculative M&A opportunities. This is related to corporate disappointment and lack of progress in deregulation and tax reform on the part of the Trump administration. Without clarity on these fronts, much of the speculative M&A pipeline will be derived from unique situations, such as companies being pressured to sell themselves due to activist involvement, or parties to transactions with potential political concerns attempting to complete deals before the mid-term elections. Investments in such situations could result in gains not only if the companies get sold, but also if tax reform does pass. Even if tax reform fails, as long as there is some sort of final resolution, the M&A pipeline should return in full force.

Strategy Allocations

The fund remains weighted according to our strategic target allocations: 23% to DoubleLine; 17% each to Loomis Sayles, FPA, and Water Island; 16% to DCI; and 10% to Passport. We use the fund’s daily cash flows to bring the manager allocations toward their targets when differences in shorter-term relative performance cause divergences.

Sub-Advisor Portfolio Composition as of Septmber 30, 2017
(Exposures may not add up to total due to rounding)

DCI Long-Short Credit Strategy

Bond Portfolio Sector Long Exposures as of 9/30/17
Consumer Discretionary 16.5%
High Tech 9.8%
Energy 9.1%
Materials 8.2%
Consumer Non-Discretionary 6.8%
Media 6.1%
Investment Vehicles / REITs 5.6%
General 3.9%
Aerospace 3.7%
Utilities 3.5%
Transportation 3.4%
Financial companies 2.8%
Equipment 2.4%
Insurance 1.7%
Banks 1.3%
Other Financials 1.0%
Pharmaceuticals 0.2%

 

DCI combined CDS + cash bond portfolio gross exposures:
Long 242%
Short -173%

 

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 9/30/17
Cash 1.8%
Government 1.3%
Agency Inverse Floaters 3.8%
Agency Inverse Interest-Only 4.4%
Agency CMO 8.5%
Agency PO 2.5%
Collateralized Loan Obligations 1.2%
Commercial MBS 1.4%
ABS 3.7%
High-Yield 0.1%
Municipals 2.6%
Non-Agency Residential MBS 68.7%
Total 100.0%

 

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 9/30/17
U.S. Stocks 37.7%
Foreign Stocks 10.4%
Bonds 7.0%
Other Asset-Backed 0.6%
Limited Partnerships 0.4%
Short Sales -7.9%
Cash 43.9%
Total 100.0%

 

Loomis Sayles Absolute-Return Fixed-Income Strategy
Exposures as of 9/30/17

Long Total
Short Total
Net Exposure
Securitized 22.4% -0.8% 21.6%
High-Yield Corporate 13.1% -2.1% 11.0%
Bank Loans 10.0% 0.0% 10.0%
Investment-Grade Corp. 8.9% -2.3% 6.5%
Dividend Equity 10.5% -4.5% 6.0%
Convertibles 3.3% 0.0% 3.3%
Emerging Market 7.0% -4.7% 2.4%
Global Credit 1.6% 0.0% 1.6%
Currency 11.8% -12.3% -0.6%
Risk Management 0.6% -3.4% -2.8%
Global Rates 35.0% -83.6% -48.6%
Subtotal
124.2%
-113.7%
10.4%
 
Cash & Equivalents
16.5%
0.0%
16.5%

 

Passport Capital Long-Short Equity Strategy
Exposures as of 9/30/17

Sector Long Short Net
MENA 27.6% 0.0% 27.6%
Information Technology 12.9% -3.3% 9.6%
Emerging Markets 18.5% -3.5% 15.1%
Consumer Discretionary 11.8% -5.2% 6.6%
Financial 2.7% 0.0% 2.7%
Health Care 5.3% 0.0% 5.3%
Industrial 3.3% -4.9% -1.6%
Energy 8.5% -8.9% -0.5%
Materials 0.0% -1.8% -1.8%
Diversified 0.7% -0.4% 0.3%
Total 91.3% -28.0% 63.3%

 

Water Island Arbitrage and Event-Driven Strategy
Sub-Strategy Long Exposures as of 9/30/17

Long Short Net
Equity Merger Arbitrage 61.6% -10.2% 51.5%
Equity Special Situations 25.7% -22.2% 3.4%
Credit Opps/Special Sits 17.0% -1.5% 15.5%
Total 104.3% -33.9% 70.4%